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See Moseley 2012a, 2012b, and forthcoming for previous critiques of marginal
productivity theory.
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The theoretically invalid aggregate production function is also widely used other fields
of economics, most notably macroeconomic growth theory, development economics and
economic history.
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Fixed proportions
The best known disqualifier for the existence of marginal products is
production processes with fixed proportions between the inputs, usually discussed as
fixed proportions between K and L. In many production processes, machines must be
used with a fixed number of workers; adding an extra machine does not increase output
unless an extra worker is also added to run the extra machine. Miller (2000) discusses
and cites a wide range of empirical studies (including by Edwin Mansfield, Joe Bain, A.A.
Walters, the NBER, and joint studies by the Fed and the Census Bureau) that generally
conclude that capital and labor in US manufacturing are usually employed in fixed
proportions:
In short, manufacturing firms generally adjust output in the short run by
increasing or decreasing the time in which capital and labor are used together.
Fixed proportions seem more suited to describing short-run manufacturing
processes than do variable proportions. (Miller 2000, p. 123)
However, fixed proportions means that the marginal products of capital and labor cannot
be separated, and thus the demand for capital and the demand for labor cannot be derived
independently and the prices of capital and labor cannot be determined independently.
Material inputs
A lesser known, but equally devastating disqualifier for the existence of
marginal products is the existence of material inputs in goods-producing industries (the
M in production functions). In these industries, it is not possible to increase output by
increasing capital (or labor) without also increasing material inputs (e.g. it is not possible
to produce another car without adding more windows, tires, etc.). In this case, K (or L)
and M are not mutually independent. An increase of K (or L) requires a complementary
increase of M in order to produce more output, and thus the necessary condition for the
existence of marginal products is not satisfied. It is another kind of fixed proportions,
except that in this case it is not a necessary fixed proportion between two inputs (capital
and labor), but rather a necessary fixed proportion between material inputs and output.
The main way that the problem of material inputs has been dealt with especially
in empirical work has been to assume away the problem, i.e. to assume that the
production functions are value added production functions, without material inputs.
However, this attempted solution does not work, because a production function is a
physical concept and value added is a nominal price concept the difference between the
price of the output and the prices of intermediate inputs. Prices and nominal value added
do not exist in engineering production plans. One can subtract the price of material
inputs from the price of the output to calculate nominal value added, because both prices
are in nominal terms which are commensurable. However, one cannot subtract the
physical quantity of material inputs from the physical quantity of output, because
materials and output in a given firm are different kinds of physical goods which are not
commensurable (e.g. what is the value added product of a car? a car without wheels?).
There is no common unit of measure in terms of which this subtraction of physical
quantities of inputs and outputs could be made. Therefore, a value added production
function is an oxymoron.
A more sophisticated attempt to solve the problem of material inputs is to assume
that the production function is separable, in such a way that capital and labor are
separable from material inputs, which allows for sequential optimization first materials
are held constant and firms optimize quantities of K and L to produce net output
(sometimes called real value added), and then firms optimize quantities of materials
and net output to produce gross output (Berndt and Christensen 1973, Arrow 1985,
Frondel and Schmidt 2004). However, the condition for separability is that the marginal
rate of substitution between capital and labor must be independent of the quantity of
materials (first articulated by Leontief 1947 and often called the Leontief condition),
which in turn requires that the production functions must be twice differentiable (because
the marginal rate of substitution is a ratio of partial derivatives of capital and labor; see
below). But production functions with material inputs are not even differentiable once.
Therefore the condition for separability is obviously not satisfied in production functions
with material inputs, and separability does not solve the problem of material inputs in
marginal productivity theory.3
Another sophisticated attempt to solve the problems of fixed proportions and
intermediate inputs has been the argument that, even though some factor proportions are
fixed within industries, the same set of factors are used in different industries, and in
different proportions; so that in this case changes in factor prices will lead to changes in
relative output prices and thus to changes in the demands for output, which feed back to
changes in the demand for inputs. In this way, substitution via consumption can play
Arrow 1985 has said that real value added is a latent concept which cannot be directly
observed. I would go further and say that real value added in physical terms is a does not
exist. Arrow continued: Without the separability assumption, however, it is hard to
assign any definite meaning to real value added, and probably the best thing to say is that
the concept should not be used when capital and labor are not separable from materials in
production. (p. 458; emphasis added) However, Arrow seems to have forgotten that
capital and labor are generally not separable from materials in production functions
because production functions with material inputs are not twice differentiable. Thus,
following Arrows advice, we should not use the concept of real value added or net
output. Value added cannot be reasonably deflated because it is not the product of a price
and an existing quantity of output.
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the same role as input substitution within industries, and downward-sloping factor
demand curves can be derived. This argument was pioneered by Cassel in 1924.4
However, Stakelbergs critique of Cassel showed that the necessary condition for
this substitution via consumption to yield determinant input prices (sometimes called
the Cassel Condition) is that every set (or combination) of n inputs that are used in fixed
proportions within industries must also be used in at least n different industries.
Otherwise, some of the input prices will not be determined. However, once all the
specific machines and equipment and intermediate inputs used in fixed proportions in
many modern production processes are specified, it is highly unlikely that this stringent
condition will be fulfilled. Therefore, this more sophisticated defense of marginal
products and marginal productivity theory is also a failure.
Furthermore, even if the Cassel condition is miraculously satisfied for all sets of
fixed proportion inputs in the economy, it would still not be true that the prices of these
inputs are equal to (or determined by) their marginal products, because the marginal
products of these fixed proportion inputs do not exist. At best (i.e. assuming the Cassel
condition is satisfied), one could derive an inverse relation between the prices of inputs
and the demand for these inputs; but one cannot say that the prices of inputs are
determined by their marginal products. Marginal productivity theory continues to be
invalidated by the non-widespread existence of marginal products.
This summary of Cassels argument and Stakelbergs critique (next paragraph) is based
on Mandler 1999, Chapter 2.
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and the RTS change (the latter due to diminishing returns). The elasticity of
substitution () is the relation between the percentage change in K/L that occurs in
response to a given the percentage change in the RTS, which can be expressed in terms of
natural logs as follows:
(1)
However, once again, since marginal products do not exist in many production processes,
neither does the rate of technical substitution and thus neither does the elasticity of
substitution between K and L
It is argued further that in perfect competition equilibrium, the ratio of marginal
products is equal to the ratio of factor prices:
MPL/MPK = PL/ PK
Thus the elasticity of substitution at the equilibrium point on an isoquant can be
reformulated as:
(1)
This formulation of the elasticity of substitution is used to analyze and estimate the
substitution of inputs in response to a change in their relative prices. However, this
formulation still assumes in the background that marginal products exist (but they often
do not) and also adds the unrealistic assumption of perfect competition.
In summary, marginal productivity theory is a very unrealistic theory which
cannot reasonably be used to analyze the distribution of income in the real world.
Marginal products often do not exist, which means that diminishing returns and the
elasticity of substitution also do not exist, and the whole theory falls apart and lacks a
coherent logical foundation. In addition, the concept of diminishing returns assumes that
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technology remains constant and thus cannot be used of explain trends in the distribution
of income in real economies in which technology is constantly changing.
Tom Palley has commented in a recent blog that mainstream economists have
decided to ignore the logical incoherence of marginal productivity theory. (Palley
2014) But this is not acceptable scholarly and scientific practice. We should not let
mainstream economists get away with this scientific malpractive.
/Y = (/K) (K/Y)5
where /Y is the capital share (i.e. the share of profit in total income), /K is the rate of
return to capital (i.e. the rate of profit, the ratio of total profit in the economy to the total
capital invested), and K/Y is the capital-income ratio (or the capital-output ratio).
According to Pikettys estimates, the K/Y ratio generally increased in the major
economies, and his explanation for this increase is that the rate of return on capital was
greater than the rate of growth of output (the now famous inequality r > g); this
conclusion is based on a modified Howard-Domar-Solow growth model that will not be
5
Piketty expresses this equation in terms of Greek letters which stand for these ratios:
= r . I find it clearer to express the equation in terms of the ratios themselves.
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examined here. According to equation (2), this increase in the K/Y ratio by itself had a
positive effect on the capital share of income.
Piketty then invokes marginal productivity theory and assumes that the rate of
return to capital is determined by the marginal productivity of capital and further assumes
diminishing returns to capital to argue that this increase in the K/Y ratio caused the
marginal productivity of capital to decline, which in turn caused the rate of return on
capital to decline. Piketty does not provide an explanation or justification of the
assumption of diminishing returns, but just asserts it (too much capital kills the rate of
return; 215-16). He simply states that it is natural to expect that the marginal
productivity of capital decreases as the stock of capital increases. (215) He gives an
example of agriculture and oddly holds the number of workers constant while increasing
the quantity of land (the usual assumption is the other way around), and argues that it is
likely that the extra yield [the marginal product of land] of an additional hectare of land
will be limited (Pikettys definition of capital includes land). Another example is
residential housing (Pikettys definition of capital also includes residential housing; see
below for further discussion) whose product is well-being, and he argues that if a
country has already built a huge number of new dwellings, then the increase to wellbeing of one additional building would no doubt be very small. (215) The only
comment about modern capitalist industry is the next sentence which asserts: The same
is true for machinery and equipment of any kind: marginal productivity decreases with
quantity beyond a certain threshold. (215)
Piketty does not mention and does not seem to be aware that diminishing returns
in marginal production theory assumes that technology remains constant and thus cannot
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explain the decline in the rate of return to capital in recent decades in which there has
been significant technological change.
In any case, according to Pikettys equation (2), the reduction in the rate of return
to capital by itself had a negative effect on the capital share. Therefore, the net effect of
these contradictory changes on the capital share depends on the relative rates of change of
the increase in the K/Y ratio and the decrease in the rate of return to capital.
Again invoking marginal productivity theory, Piketty argues further that these
relative rates of change depend in turn on the elasticity of substitution of capital for
labor (216-17), which he defines in terms of equation (2) as the ratio of the percentage
change in K/Y to a given percentage change in the rate of return to capital:
(3)
(We will discuss below the differences between Pikettys definition of the elasticity of
substitution and the standard definition in marginal productivity theory in equation (1)
above). According to this definition and equation (2), if the elasticity of substitution
is > 1, then the capital share will increase as a result of these changes, because firms
respond to the lower rate of return on capital by replacing labor with capital on a more
significant scale.
Piketty argues that the elasticity of substitution in less developed economies is in
general < 1, and it increases along with development, so that it is in general > 1 in more
advanced economies. Technological advancement means that there are more plentiful
and more profitable possibilities for substituting machines for labor, and that firms will
do so on an increasing scale. Piketty also argues that historical estimates of the variables
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in equation (3) for advanced economies suggest that the elasticity of substitution for these
economies is in a range 1.3 and 1.6. (220-21)
In sum, according to Piketty (using marginal productivity theory), the increase in
the capital share in recent decades was caused by a combination of an increase in the K/Y
ratio, diminishing returns, and an elasticity of substitution greater than one, which meant
that the increase in the K/Y ratio was greater than the decline in the rate of return to
capital, thus resulting (according to equation 2) in an increase in the capital share of
income. As Piketty put it: Everything depends on the vagaries of technology. (216;
see also The Caprices of Technology (234); emphasis added) According to this
marginal productivity explanation, if the elasticity of substitution in recent decades had
been less than one, rather than greater than one, then the capital share of income would
have decreased, not increased.
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Solow (2014) has noted this difference between Pikettys broad definition of
capital/wealth and the neoclassical concept of capital as a factor of production, but he
calls it a small ambiguity which should not affect the long-run trends in the
capital/income ratio. But Solow should look again at the estimates.
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In addition, the price variable in Pikettys equation (1) is different from the usual
price variables in marginal productivity theory. The price of capital goods in marginal
productivity theory (PK) is a unit price, the price per unit of capital goods (whatever that
unit might be); but the rate of return to capital (r) in Pikettys equation (1) is not the unit
price of capital goods, but is instead the ratio of two aggregate nominal prices: the total
profit in the economy as a whole divided by the total capital invested.
There is also a logical problem with Pikettys definition of the rate of return to
capital. The elasticity of substitution is supposed to measure the response of capitalist
firms to a change in the relative unit prices. PK is a cost to firms, the cost that firms have
to pay to purchase (or rent) capital goods; a reduction in PK is supposed to induce firms to
substitute cheaper capital goods for labor. However, the aggregate ratio in Pikettys
equation is a profit variable, not a cost variable. It does not make sense that a reduction
in this profit ratio would induce firms to substitute capital goods for labor. In this case,
capital goods have not become cheaper, but rather have become less profitable.
We can see from these differences that Pikettys definition of the elasticity of
substitution (equation 3) is also different from the standard neoclassical definition
(equation 1). Both the numerators and the denominators in these respective definitions
are different. The numerator in the standard definition is the K/L ratio in physical terms,
whereas the numerator in Pikettys definition is the K*/Y* ratio in nominal terms. Thus
(as mentioned above), an increase in the price of capital goods by itself (without any
change in the physical ratio) would increase Pikettys nominal K* and nominal K*/Y*
ratio, but would not affect the standard physical K/L ratio. In the denominator, the ratio
of the standard elasticity of substitution is the ratio of marginal products (MPL/MPK)
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especially with a value added aggregate production function. Marginal products do not
exist in many production processes and diminishing returns is based on the unrealistic
assumption of constant technology.
Furthermore, even though Piketty seems to accept marginal productivity theory
and employs the concepts of marginal productivity theory, it is a very superficial and
non-rigorous application of marginal productivity theory, as discussed in this section.
These fundamental differences essentially leaves Pikettys explanation of the increased
capital share in recent decades without any theoretical foundation at all and reduces his
explanation to a set of assertions about the aggregate nominal ratios in equation (2),
based mainly on extrapolation from recent past trends.
One could say perhaps that Piketty is just using marginal productivity theory (or a
bastardized version of it) to demonstrate to mainstream economists that, even within their
own theory, there is no natural tendency for income shares to remain constant over time
(constant shares have been believed by many economists for a long time). I think there
may be something to that speculation. But if true, it is a bad tactical decision. One does
not need marginal productivity theory (or any other theory) to demonstrate that incomes
shares do not remain constant over time; all one needs to do is look at the data. And then
the task is to provide the best possible explanation of the increase in the capital share in
recent decades, which would provide insights into the types of government policies that
would be the most effective in offsetting the increase in the capital share. One could still
demonstrate that within marginal productivity theory there is no natural tendency for
income shares to remain constant without endorsing the theory; and one could also
discuss at least some of the well-known criticisms of marginal productivity theory, and at
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the same time present an alternative theory which would provide a better explanation of
the increase in the capital share in recent decades. By uncritically employing marginal
productivity theory to (try to) explain the increase in the capital share, Piketty reinforces
the hegemony of marginal productivity theory, which is a major piece of capitalist
ideology; and, worst of all, it does not provide a valid explanation of this important
phenomenon.
Therefore, if we want to understand the underlying causes of the increasing
capital share in recent decades we have to look elsewhere besides Piketty and marginal
productivity theory. And in fact we dont have to look far. The next section will briefly
discuss a heterodox explanation of the increasing profit share presented in various forms
by a number of authors, and based on the increasing economic and political power of
capitalists over workers in recent decades (e.g. Dumnil and Levy 2011, Mishel et al
2013, Bernstein and Baker 2013, Kotz 2014).
4. Heterodox theory of the increased profit share: economic and political power
There is an alternative and much more persuasive heterodox explanation of the
increase in the profit share (capital share) in advanced economies in recent decades. The
profit share is equal to 1 minus the wage share, and this heterodox theory usually focuses
on the wage share. According to this heterodox theory, the wage share depends mainly
on the balance of power between capitalists and workers economic power and political
power. If the balance of power shifts away from workers toward and capitalists, then the
wage share will decline and the profit share will increase, and vice versa. The balance of
economic power between capitalists and workers in turn depends primarily on: (1) the
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rate of unemployment and the threat of unemployment, (2) the mobility of capital, and (3)
the prevalence of unions. The higher the rate of unemployment or the threat of
unemployment and the greater the mobility of capital, the greater will be the power of
capitalists over workers and the lower will be the wage share of income. The existence
of unions increases the countervailing power of workers. Political power can be used to
influence labor laws and especially the minimum wage. Economic power is translated
into political power, which in turn protects and enhances economic power, all of which
leads to an increasing profit share.
In the US economy in recent decades, all of these factors have contributed to the
observed decline in the wage share and increase in the profit share. The rate of
unemployment since 1970 has been generally higher than in the early postwar period, and
the threat of unemployment has been much greater due to globalization and the enhanced
mobility of capital, and these factors have weakened the power of workers and increased
the power of capitalists in the conflict over wages. The percentage of the labor force that
are union members has declined sharply from 29% in 1975 to 11% today. In addition,
capitalists have used their increased political power (since Reagan) to weaken labor laws
(e.g. right to work laws) and to block minimum wage increases, which has resulted in a
25% decline in the real minimum wage since 1970, which contributed significantly to the
declining wage share.
I argue that this heterodox explanation of the declining wage share and increasing
profit share based on economic and political power is much more realistic and persuasive
than Pikettys explanation based on logically incoherent marginal productivity theory and
non-existent marginal products of a non-existent aggregate value added production
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Conclusion
I conclude that the profit and wage shares of income are not determined by
technology (marginal products, diminishing returns, elasticity of substitution), but are
instead determined by the balance of power and the class conflict between capitalists and
workers. If the wage share is to be increased in the years ahead, then the working class
and its allies will have to organize better and exert more economic and political power in
this ongoing class conflict with capitalists over wages and the distribution of income.
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even sought sympathy from the interviewer because of its difficulty. An excerpt from the
interview went like this:
Interviewer: Can you talk a little bit about the effect of Marx on your thinking
and how you came to start reading him?
Piketty: Marx?
Interviewer: Yeah.
Piketty: I never managed really to read it. I mean I dont know if youve tried
to read it. Have you tried? (Piketty 2014b; emphasis added)
But if this is true, then Piketty should not have said anything about Marxs theory of the
falling rate of profit in his book, and he would not have made such an egregious error.
The irony is that Pikettys own explanation of the decline in the rate of return to
capital is based on marginal productivity theory and its law of diminishing returns, and
this law does assume constant technology. Piketty (and marginal productivity theory in
general) is guilty of what he accuses Marx of! On the other hand, Marxs theory of the
falling rate of profit is not based on marginal products and diminishing returns, and does
not assume constant technology; but is instead based on the labor theory of value and
analyzes at great length the effects of technological change on the rate of profit.
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Berndt and Christensen 1973. The Internal Structure of Functional Relationships:
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Bernstein, Jared and Dean Baker 2013. Getting Back to Full Employment: A Better
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Cassel, Gustav 1924. The Theory of Social Economy, translated by Joseph McGabe,
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Dumnil, Gerard and Dominique Levy 2011. The Crisis of Neoliberalism, Cambridge
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Frondel and Schmidt 2004. Facing the Truth about Separability: Nothing Works
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Kotz, David 2014. The Rise and Fall of Neoliberal Capitalism, Cambridge MA:
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Mandler, Micnael 1999. Dilemmas in Economic Theory. New York: Oxford University
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Mishel, Lawrence, Josn Bevins, Elise Gould, and Heidi Shierholz 2013. State of Working
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Moseley, Fred 2012a. A Critique of the Marginal Productivity Theory of the Price
of Capital, Real World Economics Review, 59: 131-137.
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Theory, Real World Economics Review, 61: 115-124.
Moseley, Fred 2014. The Development of Marxs Theory of the Falling Rate of Profit in the
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